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Does Qwest Know Something U S West Doesn't?

One of the many problems with the Qwest-U S West-Deutsche Telekom menage-a-trois is a total lack of communication.

The year is barely two months old, and the risk arbitrage world is facing its first major bloodbath. The reason is that the arbitrage spread in

Qwest Communications'

(Q)

acquisition of

U S West

(USW)

widened from 6 1/2 on Monday to as wide as 36 intraday (based on a minimum exchange ratio of 1.72932 shares of Qwest for each share of U S West). The cause? Widespread press reports that Qwest is in talks to be acquired by

Deutsche Telekom

(DT) - Get Report

.

The effects ripple far beyond just the arbitrage community, however. Holders of U S West shares must be wondering if the deal with Qwest is still on, or if they will be abandoned in some behind-the-scenes maneuvering. The story was broken Wednesday by

USA Today

, and later picked up by

CNBC

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and other media. Every hour brings fresh news reports, leaks and rumors, but no guidance from the companies -- making the most disturbing aspect the silence on the parts of the companies. The two stocks, and the spread, are jerked around violently with each new piece of information.

If the general tenor of the story is true, it is a frightening development in a deal that has become beset by problems. Should Qwest agree to be bought by Deutsche Telekom, the market fears Qwest will seek to ditch the U S West transaction. Even if they take U S West along in a three-way deal, there is concern that the relative valuations will favor Qwest, at the expense of U S West holders.

U S West is unattractive to Deutsche Telekom because of the one-year approval process involved due to U S West's heavily regulated local telephone service business.

Mitigating these fears are some important protections in the merger agreement between Qwest and U S West signed last June. The agreement essentially forbids Qwest from agreeing to another deal after its shareholders approve the U S West deal, for which Qwest holders overwhelmingly voted their approval last November. The deal is scheduled to close after the

Federal Communications Commission

and the six or so states that will regulate the merged company complete their

Public Utility Commission

review processes sometime this summer.

What is most disturbing about the story is the implication that Qwest is acting not only in defiance of the merger agreement, but is doing so behind U S West's back. This deal has already developed some "cultural problems," with U S West CEO Solomon Trujillo being forced to walk the plank Wednesday, leaving behind 3 million valuable but unvested options. He apparently couldn't get along with Joseph Nacchio, CEO of Qwest and the man who will lead the combined company. Trujillo's departure lends credence to the story that Qwest is acting behind U S West's back -- if he thought the deal was not likely to close, he would never have agreed to leave.

At a time of widespread panic and a collapse in U S West shares, you would expect the companies to issue a statement reaffirming their commitment to the deal. The lack of any coordinated press release from the two companies further signals discord.

Arbs collectively are in a difficult position. This deal is very widely owned, and represents many firms' single-largest position. It had offered an annualized return in the low 20% range, and was viewed as very high quality and safe. It is difficult to add to a position that is already your largest, particularly after it has widened out by 20 points. It is already so widely owned, in fact, that Wall Street's supply of borrowable Qwest stock has been nearly exhausted. It is very difficult to find shares available to sell short.

Some of Qwest's recent run-up in price certainly reflects the hope of an attractive premium any Deutsche Telekom deal would offer. But I suspect some portion of Wednesday's gain reflects a good old-fashioned short squeeze, as panicked shorts try to rein in potential losses that would result from an announcement of a Deutsche Telekom deal at a large premium.

My take is that U S West is in a strong legal position to force Qwest and Deutsche Telekom to take it along in any deal. It will be difficult to force U S West holders to take anything less than 1.72932 times whatever Qwest holders receive per share, even if Deutsche Telekom would prefer to avoid paying U S West such a large premium. The market currently reflects a much worse outcome for U S West, and is evidence of the fear and panic today's rumors have created.

David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital was long U S West shares, short Qwest shares, and had a long position in Qwest put options, and a short position in Qwest call options, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at

dbrail@thestreet.com.